Asset pricing with loss aversion

The use of standard preferences for asset pricing has not been very successful in matching asset price characteristics, such as the risk-free interest rate, equity premium and the Sharpe ratio, to time series data. Behavioral finance has recently proposed more realistic preferences such as those with loss aversion. Research is starting to explore the implications of behaviorally founded preferences for asset price characteristics. Encouraged by some studies of Benartzi and Thaler [1995. Myopic loss aversion and the equity premium puzzle. The Quarterly Journal of Economics 110 (1), 73–92] and Barberis et al. [2001. Prospect theory and asset prices. Quarterly Journal of Economics CXVI (1), 1–53] we study asset pricing with loss aversion in a production economy. Here, we employ a stochastic growth model and use a stochastic version of a dynamic programming method with an adaptive grid scheme to compute the above mentioned asset price characteristics of a model with loss aversion in preferences. As our results show using loss aversion we get considerably better results than one usually obtains from pure consumption-based asset pricing models including the habit formation variant.     

Asset pricing with expectation shocks

This paper adds persistent shocks into the adaptive learning expectation formation process in stochastic growth asset pricing production and endowment economies. These expectation shocks, designed to capture psychological elements which can arise from news, changes in sentiment, herding and bandwagon effects, generate waves of optimism and pessimism in equity price forecasts. The paper estimates parameters of the expectation shock and adaptive learning process with the method of simulated moments, and compares simulation results to U.S. economic and financial market stylized facts. Numerical results for both the estimated production and endowment economies show that the expectation shock model matches several of the stylized facts better than does a model that assumes rational expectations or adaptive learning alone.     

Asset pricing for inefficient markets: Evidence from China and India

Over last four decades, evidence of market inefficiencies has been widely documented by several scholars for all major stock markets in the globe. Chinese and Indian markets are not exempt. Inefficiencies in these markets are described by many authors as roots of all mispricing. Mispricing might be the outcome of application of familiar asset pricing models which may mislead an investor into adopting inappropriate policies for his new investments or for reallocating his old investments. In an alternative approach, we propose a transformation on original market returns in the objective of relaxing the strong assumption of market efficiency behind application of an asset pricing model. This modification will widen the scope of rational models on asset pricing ranging from an efficient to an inefficient market.     

Monopoly pricing with dual-capacity constraints

This paper studies the price-setting behavior of a monopoly facing two capacity constraints: one on the number of its consumers, and the other on the amount of products it can sell. The characterization of the firm's optimal pricing and optimal customer mix as a function of its two capacities reveals a rich structure. In contrast to the results under one-dimensional capacity constraints with constant marginal cost of production, a firm may optimally respond to an exogenous reduction in one of its capacities by decreasing one of its prices. Moreover, neglecting the existence of the second capacity constraint can reverse some policy interventions' effects on consumer welfare. In particular, easing a regulatory restriction on one of the constraints may harm the average consumer.     

Spatial duopoly with discriminatory pricing

The concept and existence of an equilibrium is established for profit maximizing competitors whose decisions involve choices of both delivered price schedules and firm locations. Each firm faces a production function; each is allowed to locate in the plane and to set discriminatory prices. Any transport cost function that is continuous in the firm location variable may be used. It is shown that the locations of the two firms are in equilibrium if each firm is minimizing social cost (i.e., the total cost to the firms of supplying the market with the good it demands is minimized) with respect to the opponent's fixed location.     

Higher knowledge for higher aspirations

With escalating expectations and opportunities for HR professionals to add greater value comes the mandate for greater knowledge about the fundamental driving forces of business. Business leaders and employees increasingly assume that HR professionals have foundational knowledge of HR concepts and practices. But to create competitive advantage from that knowledge, HR professionals must be fully versant about external business realities that directly or indirectly influence how to apply that knowledge. We examine four of the most central categories of external business knowledge: advancements in technology, the causes and effects of economic and regulatory turbulence, the dynamics of business globalization, and changes in population demographics. With knowledge about these fundamental business drivers and their supporting data, HR professionals will be more able to make credible and accurate strategic contributions to business discussions and to proactively build more centrally relevant HR practices. © 2005 Wiley Periodicals, Inc.     

Electricity derivatives pricing with forward-looking information

In order to increase overall transparency on key operational information, power transmission system operators publish an increasing amount of fundamental data, including forecasts of electricity demand and available capacity. We employ a fundamental model for electricity prices which lends itself well to integrating such forecasts, while retaining ease of implementation and tractability to allow for analytic derivatives pricing formulae. In an extensive futures pricing study, the pricing performance of our model is shown to further improve based on the inclusion of electricity demand and capacity forecasts, thus confirming the general importance of forward-looking information for electricity derivatives pricing. However, we also find that the usefulness of integrating forecast data into the pricing approach is primarily limited to those periods during which electricity prices are highly sensitive to demand or available capacity, whereas the impact is less visible when fuel prices are the primary underlying driver to prices instead.     

Option pricing with stochastic volatility models

A general class of models for derivative pricing with stochastic volatility is analyzed. We include the possibility of jumps for the paths of the asset's price and for those of its volatility. We also consider the case of correlation between the process of the asset's price and that of its volatility. In this way we are able to give a unifying view on most of the models studied in the literature. We will examine theoretical issues related to the market price of volatility risk, the equivalent martingale measures and the possibility of obtaining a numerically tractable formula for contingent claim pricing. Finally, we propose some methodologies to test the behavior of stochastic volatility models when applied to market data.     

Crack spread option pricing with copulas

A copula-based approach for pricing crack spread options is described. Crack spread options are currently priced assuming joint normal distributions of returns and linear dependence. Statistical evidence indicates that these assumptions are at odds with the empirical data. Furthermore, the unique features of energy commodities, such as mean reversion and seasonality, are ignored in standard models. We develop two copula-based crack spread option models using a simulation approach that address these gaps. Our results indicate that the Gumbel copula and standard models (binomial, and Kirk and Aron (1995)) mis-price a crack spread option and that the Clayton model is more appropriate. We contribute to the energy derivatives literature by illustrating the application of copula models to the pricing of a heating oil–crude oil “crack” spread option.     

National pricing with local quality competition

We study the incentives of national retail chains to adopt national (uniform) prices across local markets that differ in size and competition intensity. In addition to price, the chains may also compete along a quality dimension, and quality is always set locally. We show that absent quality competition, the chains will never use national pricing. However, if quality competition is sufficiently strong there exist equilibria where at least one of the chains adopts national pricing. We also identify cases in which national pricing benefits (harms) all consumers, even in markets where such a pricing strategy leads to higher (lower) prices.     

Indifference pricing with uncertainty averse preferences

We consider the indifference valuation of an uncertain monetary payoff from the perspective of an uncertainty averse decision maker. We study how the indifference valuation depends on the decision maker’s attitudes toward uncertainty. We obtain a characterization of comparative uncertainty aversion and various characterizations of increasing, decreasing, and constant uncertainty aversion.     

Robust firm pricing with panel data

Firms often have imperfect information about demand for their products. We develop an integrated econometric and theoretical framework to model firm demand assessment and subsequent pricing decisions with limited information. We introduce a panel data discrete choice model whose realistic assumptions about consumer behavior deliver partially identified preferences and thus generate ambiguity in the firm pricing problem. We use the minimax-regret criterion as a decision-making rule for firms facing this ambiguity. We illustrate the framework’s benefits relative to the most common discrete choice analysis approach through simulations and empirical examples with field data.     

Road pricing with optimal mass transit

This paper considers the second-best policy problem that arises when auto travel is priced below its marginal cost and there is a substitute mass transit mode. Using analytical methods, a global comparison is made between the second-best levels of transit service and the fare and their first-best levels. The fact that the results are global permits an application to road pricing not possible with the local results of Kraus (2003).     

Peak load pricing with spatial diffusion

The demand for public utility service varies not only temporally but spatially as well. The analysis of the problem of meeting these variations in system load with optimum plant capacity within the framework of a price determination structure is the objective of this paper. No simple cost-based solution proves possible. The solution presented, under a social welfare-maximization criterion, is similar to the joint product pricing discussed by Marshall. The characteristics of peak load pricing developed apply to the profit-maximizing firm as well as to the welfare-maximizing firm. With a profit-maximization objective, price will exceed rather than equal marginal cost. When regulation is imposed, whatever its form, normally there will be a price reduction as the output of the firm is moved closer to the welfare-maximizing level.     

Graduates' career aspirations and individual characteristics

Using the basic distinction between organisational and post‐organisational career orientation, this article examines preferences of business school graduates for different types of career fields and systematic differences between people with different career orientations in terms of behavioural characteristics as well as personality traits. The results show that business school graduates clearly distinguish between organisational and post‐organisational career fields. Graduates with post‐organisational career aspirations display attributes of high flexibility, leadership motivation, selfpromotion/self‐assertion, self‐monitoring, networking and less self‐consciousness. For individuals preferring an organisational career pattern, inverse relationships apply. Some implications of the findings for HR practice are discussed.     

Asset prices with non-permanent shocks to consumption

Most standard asset-pricing models assume that all shocks to consumption are permanent. We relax this assumption and allow also for non-permanent shocks. In our specification, the long-run mean of consumption growth is constant; consumption levels are subject to short-run deviations from their long-run trend. The implications of our model are dramatically different from those obtained in the prior literature. A canonical and parsimonious asset pricing model with CRRA preferences and non-permanent shocks can reproduce the equity premium, high return volatility and return predictability with a coefficient of relative risk aversion below ten. This finding suggests that non-permanent shocks can play an important role in explaining asset pricing puzzles.     

Auctions with endogenous participation

We study endogenous-participation auctions where bidders only know the number of potential participants. After seeing their values for the object, potential participants decide whether or not to enter the auction. They may not want to enter the auction since they have to pay participation costs. We characterize equilibrium bidding strategies and entry decisions for both first- and second-price sealed-bid auctions when participation is endogenous. We show that there is a pure strategy entry equilibrium where only bidders with values greater than a certain cut-off point actually bid. In this context, both types of auctions generate the same expected revenue. We also show that, contrary to the predictions of the fixed number of bidders literature, the seller's expected revenue may decrease when the number of potential participants increases. In addition, we show that it is optimal for the seller to charge an entry fee, which contrasts with results from the existing literature on auctions with entry. As in the fixed-n literature, we show that first-price auctions generate more expected revenue than second-price auctions when buyers are risk-averse. Finally, we characterize the optimal auction – the auction that maximizes the seller's expected revenue – by using a direct revelation mechanism. The optimal auction involves a reserve price larger than the optimal reserve price in the fixed-n literature. The winner's payment is the second highest bid less the participation cost and losers receive a subsidy equal to the participation cost. Received: 17 August 1998 / 21 September 1999     

Asset Pricing with Observable Stochastic Discount Factors

The stochastic discount factor model provides a general framework for pricing assets. By specifying the discount factor suitably it encompasses most of the theories currently in use, including CAPM and consumption CAPM. The SDF model has been based on the use of single and multiple factors, and on latent and observed factors. In most situations, and especially for the term structure, single factor models are inappropriate, whilst latent variables require the somewhat arbitrary specification of generating processes and are difficult to interpret. In this paper we survey the principal different implementations of the SDF model for bonds, equity and FOREX and propose a new approach. This is based on the use of multiple factors that are observable and modelling the joint distribution of excess returns and the factors using a multi–variate GARCH–in–mean process. We argue that in general single equation and VAR models, although widely used in empirical finance, are inappropriate as they do not satisfy the no–arbitrage condition. Since risk premia arise from conditional covariation between the returns and the factors, both a multi–variate context and having conditional covariances in the conditional mean process, is essential. We explain how apparent exceptions, such as the CIR and Vasicek models, in fact meet this requirement — but at a price. We explain our new approach, discuss how it might be implemented and present some empirical evidence, mainly from our own researches. Partly, to enable comparisons to be made, the survey also includes evidence from recent empirical work using more traditional approaches.     

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